2008, of course,
was the worst year for the stock markets in memory. Weíve never
seen anything like it in our lifetimes. The Great Depression of the
1930s was worse, but in order to have been old enough to care about
the stock markets back then a trader would have to be around 95
years old today. For all but that elderly infinitesimal fraction of
todayís traders, 2008 was utterly unprecedented.

Until the end of
August, 2008 was a garden-variety bear year with the flagship S&P
500 stock index (SPX) sporting a manageable 12.7% year-to-date
loss. But then the stock panic ignited and equity prices fell off a
cliff. The SPXís losses snowballed, falling another 29.6% to
end the year down a colossal 38.5%. Iíve never seen anything like
it. And neither has anyone else who hasnít been around for nearly a
century.

Iíve written
plenty about this
stock panic in recent months. It was defined by epic volatility
that rocketed off the charts to levels never before witnessed. But
as discussed in our current
monthly newsletter,
by mid-December this extreme panic volatility had finally bled
away. Normal market conditions were gradually returning, the Great
Stock Panic of 2008 had ended. And not a day too soon, good
riddance to it!

While the
technical damage wrought by this panic was enormous, it was dwarfed
by the sentiment damage. Today the great majority of investors and
speculators have lost faith in the equity markets. The optimists
expect stocks to grind sideways on balance for the rest of 2009,
another bad year. And the pessimists expect the end of the world, a
plunging 2009 with more unprecedented stock-market losses.

Like everyone
else, I am trying to divine what surprises 2009 might hold so I can
position my own capital accordingly as well as advise our
subscribers about the highest-probability-for-success strategies
this year. So this week, I decided to see what stock market history
tells us about years following stock panics. Do the markets tend to
grind sideways after big down years? Plunge farther? Even rise?

Before we begin,
it is really important to consider the distinction between a
stock panic and a stock-market crash. Although used interchangeably
by most investors, they are very different events. The dictionary
defines a panic as ďa sudden widespread fear concerning financial
affairs leading to credit contraction and widespread sale of
securities at depressed prices in an effort to acquire cash.Ē Sound
familiar?

This is certainly
what we witnessed in late 2008, a bubble in fear. Excessive
government intervention led to extreme fear about what the
government knew that the general markets did not. In this
hyper-fearful environment, investors dumped stocks at frightening
rates to raise cash. While cash wasnít yielding anything, at least
it would preserve principal through the surrounding conflagration.
As this choking fear spread to banks, they quit lending so credit
dried up. This is classic panic stuff.

Meanwhile a crash
is ďa sudden general collapse of the stock marketĒ. Technically
crashes are more extreme than panics, a 20% decline in major stock
indexes in 2 days (3 at most). During 2008ís panic, the
SPXís biggest 2-day and 3-day declines were just 12.4% and 13.9%.
Bad, no doubt, but still nowhere close to the classic 20%+ crash
metric. October 1929 (DJIA) saw 23.0% in 2 days while October 1987
(SPX) saw 24.6% in 2 (20.5% in 1). Crashes are not panics and
panics are not crashes.

They even happen
at different times. Crashes emerge suddenly off of very high
stock prices after a powerful secular bull. As events spawned
from euphoria, they generally arenít taken too seriously at the
time. Within the weeks immediately after, enthusiastic bulls are
aggressively buying ďthe dipĒ. These events are perceived as a mere
technical anomaly at the time, not the harbinger of a coming secular
bear which is usually what they portend.

Conversely panics
cascade into existence in weak markets. They happen near the
ends of bears off of already-low stock prices. They slowly evolve
over months, not days like crashes. They lead to such morose
sentiment that nearly everyone assumes the panic-driven stock lows
are going to persist indefinitely. Instead of being seen as a
technical anomaly, at the time they are viewed as fundamentally
rational and the herald of depressed stock prices for years to come.

So as you read
this essay, realize that panics and crashes are different types of
events that are not interchangeable. They do both result in stock
prices falling far faster than normal. But they happen at different
times, unfold at different speeds, and portend very different
post-event outcomes. This distinction is not just academic, it
could make a world of difference in how your capital performs in
2009.

To start this
analysis, I looked at the calendar-year returns in the SPX. It is
the best representation of general-market performance today, the
benchmark from which all market professionals measure their own
performance. It has a broad cross section of strong companies
representing the entire US economy. It is also
market-capitalization weighted, meaning large companies have more of
an impact on this index than small companies. This is far superior
to stock-price-weighted indexes like the Dow 30.

It is true that
calendar-year returns are somewhat arbitrary. We could just as
easily consider annual returns from August 9th to August 8th, or any
other permutation of dates. Nevertheless, we all think in
calendar-year terms so they are the most relevant for market
psychology. It is a standard everyone finds acceptable despite its
inherent arbitrariness. Hereís how the SPX did over its entire
58-year history.

Over the past half
century, generally the stock markets rose. The average return
across all these years, including 2008ís horrific loss, was +8.2%.
This is impressive considering all the turmoil seen since 1950. And
it understates how equity investors did over this span since this is
pure capital gains not including dividends. The SPXís up years
averaged 16.6% gains while its down years averaged 13.9% losses.

2008ís 38.5% loss
is clearly unprecedented within the SPXís history. We only saw 2
other years come remotely close, 1974 and 2002. Both were at the
ends of big cyclical bears
within secular
bears in the same phase in their respective
Long Valuation
Waves. But still, compared to 1974ís 29.7% loss and 2002ís
23.4% loss, 2008ís massive 38.5% was off the charts. It was
isolated too, not the end of a multi-year decline like these
previous big down years. 2008 was truly the first stock panic
witnessed in modern history.

The uniqueness of
this panic aside, letís just lump all big down years together for
this study. To me, a big down year is a 20%+ loss in the US stock
markets. Anything much less is not all that uncommon and fairly
typical in bear markets. Interestingly if you remove 1974, 2002,
and 2008 from the equation, the SPXís average down year was only
10.0%. And its all-year average return jumps to +10.3%.

And what happened
after big down years? After falling 20%+ in a calendar year did the
stock markets grind sideways like the optimists expect today? Did
they plunge even farther like the pessimists expect in 2009?
Neither of the above! 1974ís 29.7% loss was followed by 1975ís
massive 31.5% gain. And 2002ís 23.4% loss was followed by
2003ís 26.4% gain. These were huge up years, among the best
in the SPXís entire history.

Did January 1975
and January 2003 feel much different than January 2009? Was
everything idyllic back then with hyper-bullish traders looking
forward to great years? Heck no! Both times felt exceedingly
awful. You probably remember how bad early 2003 felt, and ask any
older trader about early 1975. At the starts of both of these big
up years, the landscape looked very bleak and hopeless. In fact in
Q1 1975, the US economy shrunk at a brutal 4.8% annual rate.
The markets always feel horrible right after big down years.

But itís crucial
to remember the central axiom of contrarianism, that the markets are
self-balancing mechanisms. The markets abhor emotional
extremes. If greed grows too great, the markets fall sharply to
eradicate it. If fear spirals out of control, the markets rise
sharply to bleed it off. The more extreme one of these emotions,
the more extreme the reaction to wipe it out. Since 20%+ down years
generate extreme fear, the years immediately after tend to have
incredible overshooting gains to offset the fear bubbles.

The average losses
in 1974 and 2002 were 26.5%, and the average gains in 1975 and 2003
were 29.0%. This makes a reversal factor of 1.1x. In 2008 we saw a
38.5% loss. If 2009 sees a reversal of similar magnitude to the
average of every other post-20%-down-year year in SPX history, this
1.1x suggests weíll see a 42.4% gain in the SPX in
calendar 2009. How many people have you seen forecasting a 40%
up year in 2009? Zero I bet.

Now this probably
sounds like sheer lunacy if youíre steeped in popular market culture
today, which universally expects a flat-to-rotten year. But
consider the mathematics of losses, which make such an outcome much
more plausible. After a big loss, a big gain is far easier to
achieve than one might expect. Gains after big losses, even if they
exceed the loss, are not symmetrical and donít fully undo the
decline.

Imagine a stock
index at 100. It falls to 50 one year, a 50% loss. The next year,
it rises 50%. Yet this doesnít wipe out the panic year. A 50% rise
from an indexed level of 50 only takes it to 75. It is still
down 25% from when the panic year began. So if the SPX rises
40% in 2009, an outcome Wall Street considers flat-out impossible,
then this index would still be down 13.9% from the end of
2007. The markets can still remain weak overall, yet the post-panic
rebound year is utterly awesome.

As a student of
the markets, I couldnít just end this thread of research here. The
SPX is todayís benchmark, but 58 years is still not enough time to
find another panic with which to compare 2008. So I also looked at
the classic Dow Jones Industrial Average. Also known as the Dow 30
today, its history extends way back to 1885. While it is a flawed
price-weighted index (a $100 stock has twice the influence on this
index as a $50 stock even if the latter company has a much larger
market cap), it is the classic historical benchmark.

Over 123 years,
the DJIA (it wasnít increased to 30 stocks until 1928) has averaged
returns over all years of +6.8%. This does not include dividends of
course. Its average up year was 19.5% while its average down year
was 14.1%. As you can see in this chart, even in the context of
this long swath of market history 2008ís 33.8% loss was
extraordinary. There have only been 5 other years that saw 30%+
declines and 10 that have seen 20%+ declines. Losses this big are
pretty darned rare.

2008 was actually
this indexís third worst year ever, after an unbelievable 52.7% loss
in 1931 in the bowels of the Great Depression and the 37.7%
witnessed in the Panic of 1907. Thatís right, a panic. In all the
historical books on the stock markets Iíve read, the 1907 event is
always the most prominently discussed panic even if the book was
written after the Great Depression. 1907 is probably the
closest analogy to 2008.

But before we
delve into those 1907 events of a century ago, the Great Depression
is very relevant. In 1929, the DJIA fell 17.2%. This is really
pretty mild considering the mystique the infamous 1929 crash has
today. This crash happened at the top after a long secular bull.
The analogous event in modern times is the sharp selloff in March
and April 2000 after the secular stock bull of the 1980s and 1990s
climaxed in the tech-stock bubble. 2008, nearly a decade into a
secular bear, is not the time to look for a crash.

The Great
Depression snowballed between 1930 and 1932 when the DJIAís
calendar-year losses ran 33.8%, 52.7%, and 23.1%. Interestingly,
1933ís enormous 66.8% gain in the Dow 30 was its second best year
ever witnessed, so the rebound principle held even after the Great
Depression. The best year ever was 1915ís colossal 81.7% gain. If
you think we had it bad in 2008, in 1914 during World War I the US
stock markets closed their doors totally from late July to
mid-December. There was no trading for almost 5 months!

Many people think
we are entering a new Great Depression today. If that is the case,
then 2009 will indeed be bad. But I donít see a neo-Great
Depression emerging for a wide array of reasons, as I discussed in
depth for our subscribers in the 12/08 issue of
Zeal Intelligence.
The primary reason is the Great Depression saw the US economy
literally cut in half between 1929 and 1933. Even the most
raging bear today doesnít expect US economic output a few years from
now to be half of 2007ís levels.

To get to half, US
GDP needs to shrink by 15.9% annually over each of the next 4
years or 20.6% annually over each of the next 3. It ainít gonna
happen. A panic is a fear event, nothing more. The economy may
contract by 1% to 3% annually for a couple years on the outside, but
there is no way we will see Depression-like economic contractions.
If you study the Great Depression, youíll probably categorically
dismiss the chance of a similar event today. It was totally unique
and driven by conditions radically different than 2008ís.

So yes, during
that Great Depression era there were big down years followed by big
down years. But this occurred nowhere else in stock-market
history. Year after year of double-digit economic contraction
certainly warranted such an outcome. Today even the raging
pessimists think 2009ís overall economic growth will be flat to
mildly negative. So I think we are justified in excluding the
Depression years from this analysis.

Ex-Depression,
after 20%+ down years the average DJIA gain in the subsequent year
was 25.3% across 7 episodes. The worst year was 1894ís 0.6% loss
following 1893ís 24.6% loss. Every other subsequent year was
positive, with only 2 being in the teens and 4 seeing big gains over
28%. So unless you are betting on a neo-Great Depression, you are
fighting history if you expect 2009 to be down. 123 years of
history suggests it will be up big, at least the 25% average
of all such years outside of the early 1930s.

Among these
historical episodes, perhaps the most relevant to today is the
infamous Panic of 1907. It was the most famous event in market
history until the Great Depression, even though most investors today
arenít aware of it. In 1907 the DJIA plunged 37.7%. As the next
chart shows, this decline looked uncannily like todayís. Then in
1908, despite the widespread fears in late 1907, the DJIA soared
46.6%.

Realize there is
no trickery in this chart. Both axes are zeroed so that there is no
distortion in the relative slopes of the DJIA in 1907 (when it had
12 stocks) and the Dow 30 in 2008. The resemblance of these two
panics, separated by the vast gulf of a century, is uncanny. I am
sure I could pass one chart off for the other and almost no one
would be the wiser. This pair of panic events was incredibly
similar.

How can this be?
The markets are vastly different today than 101 years ago. Very
true. But one thing that hasnít changed is human emotions. Greed
and fear drives speculators today just like it did a century ago.
The interaction of these emotions with herd psychology works the
same way today as it did back then. A 10% or 20% selloff episode in
those markets was just as scary to those investors as a similar
decline is to us today.

In October 1907, a
major brokerage (Gross & Kleeberg) collapsed after a stock-cornering
speculation scheme failed. In September 2008, a major investment
bank (Lehman Brothers) collapsed after a hyper-leveraged real-estate
speculation scheme failed. Both events led to a cascading loss of
confidence among investors and bankers, the latter becoming too
frightened to lend resulting in credit becoming scarce. Then
selling begot more selling, mushrooming the panics, until everyone
remotely interested in selling had sold.

Both panics had
tops in October of the previous year (on the very same day, October
9th!). Both had similar cascading selloffs in the panic year before
the panic erupted in October. Both had similar sharp panic plunges
in October and November. Both bottomed in November (1907 on the
15th, 2008 on the 20th). Both saw similar peak-to-trough losses
over that entire sliding year (45.2% in 1907 and 46.7% in 2008).
Both felt like the end of the world at the time, and both helped
drive sharp economic contractions. The parallels in time and
selloff magnitude are amazingly similar.

But after its
November 1907 bottom, that panic started to gradually recover
despite horrendous sentiment. It even saw a couple of sharp
pullbacks after this recovery stealthily started. In 8 days in
December 1907, the DJIA retreated 8.0%. Iím sure that scared
traders into thinking the panic wasnít over yet. In January 1908,
there was a second 6.9% pullback in 8 days.

These are
provocative as weíve just seen a January 2009 DJIA pullback of 9.0%
in 6 days and everyone is freaking out. But it looks like par for
the course. The initial recovery out of panic lows is during a time
of great uncertainty and residual fear, so it is not just a nice
smooth climb back to normalcy. As usual in an uptrend, the stock
markets take two steps forward then one step back. November 2008 to
January 2009 fits this post-panic pattern perfectly.

Of course over the
next year following the November 1907 panic lows, the DJIA surged
66.8% higher! It peaked on November 13th, exactly one year after
the panic low (the 15th was a Sunday). This recovery rally was
enormous and exceedingly profitable for those brave contrarian souls
who bought in the midst of the panic at the depths of popular
despair. And this big rally happened despite the economy not
expanding again until Q3 1908. Itís a fascinating and encouraging
parallel, no?

Everywhere you
look today, Wall Street and market professionals expect 2009 to be
flat to horrible. The economy is not recovering, they claim. Yet
history shows the markets really donít care outside of a Great
Depression-like catastrophe. Stock markets recover sharply after
big down years even if the economic recovery takes longer to arrive.

As a hardcore
contrarian, I expect 2009 to follow this big-recovery-rally pattern
so I am fighting the crowd and going heavily long. Odds are 2009
will be awesome. In late December I wrote to our
Zeal Speculator
subscribers regarding the SPX, ďÖ2009 should be outstanding for the
US stock markets. I suspect a 25%+ year is virtually a certainty.
And a 50% year would not surprise me one bit.Ē I still believe
this today.

At Zeal, we do all
our own original research. We are not swayed by popular opinion and
we donít care what people think. We study the markets ourselves to
define probable outcomes and then trade accordingly. If you are
tired of the endless Wall Street groupthink, and running with the
hysterical herd emotionally, give our
acclaimed monthly
newsletter a try. Weíll illuminate todayís markets for you
based on history and show you what specific trades we are making to
capitalize on these opportunities.
Subscribe today!

The bottom line is
stock-market history is crystal clear on post-panic stock years.
Big down years are almost always followed by really big up years.
The only major exception is the Great Depression, when the US
economy was cut in half. If you donít expect a 50% economic
contraction today, then the only sound bet to make based on market
history is for a massive up year in 2009. We are talking 25%
up to maybe even 50% gains in the SPX!

It may be hard to
believe a great year is even possible today, but things always look
bleak emerging out of a panic. Residual fear lingers a long time,
actually until stock indexes finally rise far enough to fully dispel
it 6 months or so later. Stocks rebound way before the underlying
economy finally starts to recover. Going long right after a panic
is the ultimate contrarian bet, very challenging psychologically but
promising huge potential rewards.